Magazine

The Scary Side of Low Rates

June 22, 2003

To Federal Reserve Chairman Alan Greenspan's way of thinking, the natural tendency of the economy is to grow. Consumers want to buy new things and companies want to build up businesses. That's why the lingering gloom among corporate honchos has come as a surprise. Some 18 months after the recession's end -- and nearly two months after Iraq jitters were laid to rest -- corporate CEOs are still reluctant to shell out money for new investment or take on more workers. If the gloom goes on too much longer, it could snuff out the sputtering recovery.

With the corporate set so cautious, the Fed's only hope is to use cheap credit to juice up other parts of the economy, including housing and the financial sector, so much that industrialists will take heart and start investing again. The key is using rock-bottom rates to help shift executives' expectations in a more positive direction and revive animal spirits.

But with interest rates at levels not seen in more than four decades, there are risks to the strategy. Indeed, there are already signs that ultralow interest rates are spawning bubble-like behavior in the financial markets. Another danger: increased financial disruptions as everyone from money-market to pension-fund managers struggle to cope with the brand-new world of ultralow rates.

Big rate drops have put particular pressures on mortgage financiers like Fannie Mae and Freddie Mac (FRE), as property owners have rushed to prepay their home loans. While the two government-sponsored agencies have long maintained they can handle the risks, Freddie Mac's abrupt dismissal of its president on June 9 following an accounting inquiry that will lead to an earnings restatement raised questions about whether it has adequate financial controls in place. The big, so far unfounded, worry: that future financial troubles at Fannie and Freddie could hurt the housing market, one of the few bright spots of the recovery.

Indeed, in a world of cheap credit, further rate cuts could, in some cases, hurt rather than help the economy. A further fall in interest rates could decimate the money-market fund industry, which provides hundreds of billions of dollars to Corporate America via purchases of commercial paper. "You're operating in an environment that you don't know very much about," says Goldman, Sachs & Co. economist Jan Hatzius.

But that's a risk Greenspan & Co. think they have to take. Fed officials are betting that the financial system is big and flexible enough to stand the stresses and strains of the brand-new world of ultralow interest rates. And they're also willing to accept any financial bubbles those low rates may spawn, if that's what it takes to get the economy going again. In comments to international bankers on June 2, Greenspan signaled that he thought investors might be getting a bit ahead of themselves in their enthusiasm about the economy. Yet he evinced little concern about the consequences. Indeed, Greenspan seems likely to push rates even lower when the Fed meets to map monetary strategy on June 24-25. In his June 2 comments, Greenspan hinted that a further cut in the 1 1/4% interbank interest rate was in the offing as insurance against the real, though remote, risk that the economy could tip into a debilitating, deflationary downturn.

The trouble for the Fed, though, is that when it cuts rates, the money doesn't necessarily flow to the parts of the economy where it can do the most good. Despite all the money that the central bank has pumped out, industrial companies remain gun-shy about taking on new debt to finance investment. Commercial and industrial loans at banks have actually shrunk over the past year, by $75 billion according to the Fed.

Even though lending rates are extraordinarily low, chief executives in the goods-producing sector are reluctant to borrow for fear that, with prices falling and demand lackluster, they will have a hard time repaying loans. In essence, manufacturers are mired in a localized deflation and low interest rates make very little difference to them. Adjusted for expected deflation in the price of goods they sell, real interest rates for those firms "have been going up," says Wachovia Corp. economist Mark Vitner.

Fed officials say that Corporate America is also holding back on borrowing and investment because company execs are still skittish in the wake of recent accounting scandals. Rather than focusing on ways to expand their businesses, corporate execs are focused on minimizing risk and keeping their jobs.

Ultralow rates, however, are clearly fueling a surge in the stock market. One example: The state of Illinois has taken some proceeds from a $10 billion bond issue to invest in stocks. That, state officials hope, will help close a huge $35 billion pension funding gap. To some, there is a smell of irrational exuberance in the air. "It's reminiscent of the [1990s] bubble," says Henry T.C. Hu, a corporate and securities law professor at the University of Texas.

Some stock strategists also worry that cheap money is propping up companies that ought to shrink or liquidate -- and so is delaying the consolidation needed for a vigorous recovery. Kari Bayer Pinkernell, senior U.S. strategist at Merrill Lynch & Co., frets that investors' renewed infatuation with tech companies is delaying much-needed restructuring.

There's another worry, too: the creation of a bubble in the bond market. Egged on by deflation talk from the Fed, yields on Treasury securities are at 45-year lows. "There is a great deal of risk and no return in the market," says James Grant, editor of Grant's Interest Rate Observer. The big risk for bonds is that the Fed's efforts to reflate the economy will prove all too successful, leading to an eventual surge in inflation. Inflation phobes argue that given the unprecedented amount of stimulus being pumped into the economy, it's only a matter of time before price pressures build. "Greenspan has made very clear that he's going to monetize the deficit," says Rajeev Dhawan, director of the Economic Forecasting Center at Georgia State University's Robinson College of Business. "That means you're going to have inflation down the road."

For now, though, the focus is on whether the Fed will succeed in goosing growth. And in the looking-glass world of cheap credit, that's by no means clear. Money-market funds are most at risk from rock-bottom rates. Falling rates have lowered yields on money-market mutual funds so much that their 0.6% annual fees eat up close to half of their 1.3% annual return, leaving investors just 0.7%. A further sharp rate drop could put many of the funds, which are big buyers of commercial paper, out of business. If that happened, it would force issuers of commercial paper like Ford Motor Credit (F) to find other, presumably more expensive, ways to raise money.

But turning to banks for funding may not be so easy, either. In ordinary times, banks usually benefit strongly from interbank rate cuts by the Fed because they lower their cost of funds. But with bank borrowing costs already close to zero, another Fed rate won't make much difference. But it would pressure the banks to lower their lending rates, squeezing their profit margins and discouraging them from granting credit.

Pension funds are also feeling the pinch from bargain interest rates. They're required by regulation to have enough money so they can meet future obligations even if all their assets were invested at today's ultralow rates. By that standard, "pension plans are getting weaker," despite the stock market's surge, David Zion of Credit Suisse First Boston Zion states.

Greenspan & Co. are well aware of the distortions and disruptions that cheap credit could spawn. But with the economy sputtering, they have little choice but to accept the consequences of their ultralow interest-rate regime -- and hope for the best. By Rich Miller in Washington and Peter Coy in New York, with Michael Arndt in Chicago